March 26, 2009

WSJ: Have We Seen the Last of the Bear Raids?

So is that it? Is the downturn over? After bouncing off of 6500, or
more than half its peak value, and with Citigroup briefly breaking $1,
the Dow Jones Industrial Average has rallied back more than 1200
points. So, is it safe to go back in the water? Best to figure out what
went wrong first -- what I like to call a bear-raid extraordinaire.

The Dow clearly got a boost from Treasury Secretary Tim Geithner's
new and improved plan, announced on Monday, to rid our banks of those
nasty toxic assets. The idea is to form a "Public-Private Investment
Fund" to buy up $500 billion to $1 trillion worth of bad assets --
mostly mortgage backed securities (MBSs) and collateralized debt
obligations (CDOs).

While it's true that private interests can conceptually help
establish the right market price for these assets, the reality is Mr.
Geithner's public-private scheme won't work. Why? Because the pricing
paradox remains -- private parties won't overpay, yet banks believe
these assets are extremely undervalued by the market. As Edward
Yingling, president of the American Bankers Association, said recently
on CNBC, "You have to go into the securities, examine the securities,
examine the cash flow. I've seen it done, and the market is so far
below what they're really worth."

The Treasury can't just keep throwing money at the problem, but
needs instead to figure out what's really been going on -- the
aforementioned bear-raid extraordinaire that's crushed Citigroup and
Bank of America and General Electric, among others. Only then can Mr.
Geithner craft a real plan to fight back.

In a typical bear raid, traders short a target stock -- i.e., borrow
shares and then sell them, hoping to cover or replace them at a cheaper
price. Once short, traders then spread bad news, amplify it, even make
it up if they have to, to get a stock to drop so they can cover their
short.

This bear raid was different. Wall Street is short-term financed,
mostly through overnight and repurchasing agreements, which was fine
when banks were just doing IPOs and trading stocks. But as they began
to own things for their own account (MBSs, CDOs) there emerged a huge
mismatch between the duration of their holdings (10- and 30-year
mortgages and the derivatives based on them) and their overnight
funding. When this happens a bear can ride in, undercut a bank's
short-term funding, and force it to sell a long-term holding.

Since these derivatives were so weird, if you wanted to count them
as part of your reserves, regulators demanded that you buy insurance
against the derivatives defaulting. And everyone did. The "default
insurance" was in the form of credit default swaps (CDSs), often from
AIG's now infamous Financial Products unit. Never mind that AIG never
bothered reserving for potential payouts or ever had to put up
collateral because of its own AAA rating. The whole exercise was
stupid, akin to buying insurance from the captain of the Titanic, who
put the premiums in the ship's safe and collected a tidy bonus for his
efforts.

Because these derivatives were part of the banks' reserve
calculations, if you could knock down their value, mark-to-market
accounting would force the banks to take more write-offs and scramble
for capital to replace it. Remember that Citigroup went so far as to
set up off-balance-sheet vehicles to own this stuff. So Wall Street got
stuck holding the hot potato making them vulnerable to a bear raid.

You can't just manipulate a $62 trillion market for derivatives. So
what did the bears do? They looked and found an asymmetry to exploit in
those same credit default swaps. If you bid up the price of swaps,
because markets are all linked, the higher likelihood (or at least the
perception based on swap prices) of derivative defaults would cause the
value of these CDO derivatives to drop, thus triggering banks and
financial companies to write off losses and their stocks to plummet.

General Electric CEO Jeff Immelt famously complained that "by
spending 25 million bucks in a handful of transactions in an
unregulated market" traders in credit default swaps could tank major
companies. "I just don't think we should treat credit default swaps as
like the Delphic Oracle of any kind," he continued. "It's the most
easily manipulated and broadly manipulated market that there is."

Complain all you want, it worked. In early March, Citigroup hit $1
and Bank of America dropped to $3 and GE bottomed at $6.66 from $36 not
much more than a year ago. Same for Lloyds Banking Group in the U.K.
dropping from 400 to 40. Citi CEO Vikram Pandit recently announced that
the bank was profitable in January and February. (How couldn't they be?
With short-term rates close to zero, any loan could be profitable). Never mind they still had squished CDOs, it was enough to get some of the pressure off, for now.

Oddly, with the new Treasury plan, these same bear raiders are still
incentivized to manipulate the price of swaps to depress toxic
derivative prices, especially so with the government's help to get
hedge funds to turn around and buy them. Perversely, they may get
rewarded for their own shenanigans.

This week's Treasury announcement of private buyers isn't going to
magically change the depressed prices of these toxic derivatives. The
Treasury needs to fight fire with fire. If I were Mr. Geithner, I'd
pull off a bull run -- i.e., pile into the CDS market and sell as
many swaps as I could, the opposite of a bear raid. If the bears are
buying, I'd be selling, using the same asymmetry against them. Sensing
the deep pockets of Uncle Sam, the bears will back off. Worst case, the
Fed is on the hook for defaults, which they are anyway!

With the pressure of default assumptions easing, prices of CDOs
should rise, which not only gives breathing room to banks, but may
actually get these derivatives to a price where banks would be willing
to sell them, replacing toxic assets in their reserves with cash or
short term Treasurys, which ought to stimulate lending.

So are hedge funds villains? Not especially. The bear raid probably
saved us five to 10 years' of bank earning disappointments as they
worked off these bad loans. Those that mismatched duration set
themselves up to be clawed. Under cover of a Treasury bull run, banks
should raise whatever capital they can and dump as many bad loans
before the bear raiders come back. Let the bears find others to feast
on, like autos, cellular, cable and California.

Comments

Can you explain this paragraph? The reason I ask is that it seems to suggest that capital requirements contributed to this crisis by making financial companies take actions (buy or sell CDSs) that they would not otherwise do in a free market? Is there anyting to that? What is that rule about reserves and insurance and what you can carry on your books as good capital? Also seems that the AAA rating system (another regulatory construct) caused them to not otherwise value their risk properly.

"Since these derivatives were so weird, if you wanted to count them as part of your reserves, regulators demanded that you buy insurance against the derivatives defaulting. And everyone did. The "default insurance" was in the form of credit default swaps (CDSs), often from AIG's now infamous Financial Products unit. Never mind that AIG never bothered reserving for potential payouts or ever had to put up collateral because of its own AAA rating. The whole exercise was stupid, akin to buying insurance from the captain of the Titanic, who put the premiums in the ship's safe and collected a tidy bonus for his efforts."

If you are correct, then it follows that there were entities that "collaborated" to initiate the bear raid since I doubt that one or two entities could have done it on their own. Therefore, an interesting follow-up to your article would be an article describing the anatomy of the entire process beginning with the analysis, decision making, transactions required etc. Naming names & profits derived would be extremely interesting, a la Soros/Pound Sterling raid.

Andy, you've nailed it. Cronkite was right out or "Farenhiet 451"; the talking head on the video wall telling us what to think. Journalists are supposed to challenge and expose, not lull us into a stupor.